Rolls-Royce Holdings plc

The operational story is real. Group operating margin on the three core divisions has gone from −16.9% in 2020 to 18.3% in FY2025; shareholders' equity has gone from £6.0bn negative at the 2022 trough to £2.8bn positive. We forecast operating profit slightly above management's own 2028 target.

What we cannot independently justify is the combination the share price requires: consensus-like cash conversion, a required return near 7.5%, a two-decade growth runway, and a favourable SMR outcome — all at once. Any three of the four still leave the shares 12–20% overvalued.

Our reverse DCF implies a required return of roughly 6.1% on our own cash-flow path. That is not evidence 6.1% is correct — it is a measure of how much duration the market is willing to pay for. And the same discount rate applied to GE Aerospace and Safran would declare much of the high-quality aerospace aftermarket sector 40–60% overvalued. Rolls-Royce is not an outlier within its peer group, and we treat that as a reason for humility about our discount rate rather than confidence about the market's error.

Civil Aerospace is best understood as an installed-base annuity with a thin-margin hardware channel attached. Long-term service agreements bill per engine flying hour; revenue is recognised as servicing costs are incurred. A growing, young fleet therefore generates a structural cash tailwind that decays as the fleet matures.

At 31 December 2025 the net Civil Aerospace LTSA position was a £10.4bn contract liability — £11,370m of contract liabilities against £973m of contract assets. That is cash already collected against servicing yet to be performed, and it is the single most important balance in the company.

Reported free cash flow is not a clean read on earned economics while the fleet is growing — and the appropriate required return for such a long-duration stream becomes the central valuation question.

Reported Civil Aerospace margin rose from 16.6% to 20.5%, an increase of 390 basis points. Strip out all net contractual margin improvements and the core margin still rose from 14.0% to 16.7% — 270 basis points.

Approximately 69% of the margin expansion appears structural rather than attributable to contractual margin improvements.

Every series points to a finite clean-up that is running down: gross improvements are falling, catch-ups are falling, the provisions balance has shrunk by more than a fifth, and the onerous-contract line has flipped from charge to release — the signature of a release phase nearing its end. But the renegotiated contracts stay renegotiated. Management attributes the improvement to onerous-contract repricing and to time-on-wing milestones on the Trent XWB-84, and the second of those is durable economics arriving through the accounting rather than an artefact of it.

We fade net contractual margin improvements from £392m in FY2025 to £80m by FY2030, while allowing the core margin to rise from 16.7% to 20.8% as repriced contracts enter the run-rate. The result is a Civil margin of 21.9% in FY2028 — inside management's 21–23% target band, in its lower half — fading to 21.3% by FY2030. Judgement: current margins are not materially accounting-inflated; the improvement is predominantly structural; and we assume the lower half of the range long term.

FY2026 guidance implies 1,480–1,550 total shop visits. The 2028 mid-term assumption implies just 1,300–1,400 — fewer shop visits — while large-engine flying hours rise from 115–120% of 2019 to 130–140%. On its face that looks inconsistent. It is not: Rolls-Royce states the mechanism directly, with mid-term free cash flow reflecting large EFH growth to 130–140% of 2019 levels, a higher average normalised EFH rate, and the benefits of its time-on-wing initiatives with shop visits falling to 1,300–1,400 in the mid-term.

Combining roughly 10% fewer shop visits with roughly 15% more flying hours implies maintenance intensity improving by approximately 28% in three years — a single operational claim that underpins both the 2028 margin target and the 2028 cash target.

It matters twice. On margin, fewer shop visits per flying hour means lower lifetime servicing cost against the same contractual receipts — precisely what drives an upward revision to expected contract profitability. On cash, deferring shop visits also defers cash cost, extending the period over which flying-hour receipts run ahead of servicing outflows.

NBS is within roughly 1% of consensus on FY2028 revenue and operating profit, but approximately 16% below consensus on free cash flow.

The whole difference is one line

Civil Aerospace LTSA balance growth, net of risk-and-revenue-sharing arrangements, was £1.1bn in FY2023, £691m in FY2024 and £572m in FY2025. In the first half of 2026 it was £86m, against £472m in the comparable half. Management's mid-term plan assumes £0.8–1.2bn a year.

Reaching £1.0bn by FY2028 from an £86m half requires the tailwind to grow roughly twelve-fold in two and a half years. Rolls-Royce's own explanation for the H1 slowdown is that receipts grew 13% while recognised LTSA revenue grew faster still, helped by higher LTSA margins and contract catch-ups. If catch-up recognition is itself finite, the mechanism that compressed the balance build in H1 2026 does not obviously reverse.

The counter-argument is mechanical and serious. New engines generate flying-hour receipts from entry into service but do not require a major shop visit for years. A delivery ramp from 483 engines in FY2025 toward 650–750 by 2028 therefore rebuilds the balance almost automatically, provided deliveries arrive. Our own model has deliveries rising to 680 in FY2028. If the age-mix effect dominates the recognition effect, management's range is attainable and we are wrong.

Base-case forecasts

Our forecasts are built from operating drivers rather than extrapolated growth rates: Civil Aerospace services revenue from large-engine flying hours multiplied by a realised revenue-per-flying-hour rate, original equipment from deliveries, Defence as backlog conversion, Power Systems as an order-intake model.

Valuation is extraordinarily sensitive to the discount rate here, because the cash flows are long-dated. Moving the cost of equity from 10.77% to 9.00% adds 28% to core value; the raw 1.45 beta removes 16%. By comparison, doubling the length of the fade period adds under 5% and lifting terminal growth by 50bp adds barely 2%.

The valuation is a required-return question first and a cash-conversion question second — and on the required return, neither extreme is credible.

A CAPM cost of equity of 10.77% produces a fair value implying about 9.6x FY2028E EV/EBIT for a growing, net-cash, 20%-margin aftermarket annuity. Solving the other way, the share price implies a cost of equity of 6.07% and a beta of about 0.22 — a bond-like figure for a cyclical industrial. On last-twelve-months EV/EBIT Rolls-Royce sits at roughly 37.2x — essentially level with GE Aerospace at 38.6x and at a substantial premium to Safran at 24.4x.

What 1,567p requires an investor to believe

Single-variable reverse-DCF solutions are arithmetic boundary tests, not expectations. The useful exercise is to build the price out of economically coherent conditions and see how many must hold at once.

Starting from our base of 690p, reaching 1,567p requires consensus-like cash conversion — 96% of operating profit rather than our 82%, worth +112p; a required return near the market-implied level, the single largest lever, with 10.77% to 9.00% worth 215p and a further move to 8.00% with 3.0% terminal growth worth another 241p; a long explicit growth duration, extending the fade from five years to ten, worth only +70p; and a favourable SMR outcome, worth +46p.

The share price requires several favourable conditions to hold together rather than one single heroic assumption. Any three of the four leave the shares 12–20% overvalued.